Big and Small Thoughts to Start the Week

GaveKal has a good piece on what they think is happening in the Chinese economy and focus on the RMB.

1.I generally like their work, but think they are too sanguine about the risks here. Chen Long of GavelKal Dragonomics writes “if a 3% devaluation in China’s currency can trigger a global rush for the exits—as it did last week—a 20% drop could shake the world.” This is an accurate assessment, but also overlooks the highest probability scenario that a 20% drop in the RMB just has not been recognized in the pricing yet. What I mean by that is this: virtually all indicators point to the conclusion that the RMB is probably at least 10% over valued and in all likelihood 15-25%. Evidence abounds to support this conclusion. First, central banks don’t spend $150 billion every three weeks, or about $200 billion a month, to support a currency that is close to appropriately valued. Even by Chinese standards $50 billion a week is big money and there is no evidence the capital required to prop up the RMB is dropping. (See Update below). Second, if you look at a list of major currencies and their move against the dollar over the past year, China is the extreme outlier in that the RMB has only dropped 2% compared to most currencies which have lost 10-30%. If China is even on the low end of a fall relative to the US dollar, it would need to drop at least 10% and a middle of the pack fall would require it to drop about 20%. Third, if you believe strongly in information asymmetries then Chinese firms and government agencies assuming an RMB/$ value of 7 tells you that a nearly 10% drop is coming. In fact, not only are the basing assumptions on 7, but using 8 by the end of 2016. Given the typically excessively positive outlook of Chinese government agencies, I would consider these figures the absolute baseline for what to expect. That means expect at a baseline a 10% devaluation by late 2015 early 2016, and a nearly 30% drop by the end of 2016. GaveKal is right however, these movements will truly shake the world.

2.Given what we have learned we about China FX policy, we also need to revisit PBOC reserve adequacy. The most recent numbers placed them at $3.7 trillion. Since then, that number has probably dropped to between $3.4-3.5 trillion given the scale of intervention. Furthermore, we need to reduce FX reserves by an additional $200 billion as this is actually money owed to the PBOC by the China Investment Corporation currently held as overseas assets. This is not nearly as liquid as the cash and US Treasury holdings by the PBOC. That moves us down to about $3.2 trillion. I’m going to make one large assumption that I believe is perfectly reasonable and plausible, but one that I am sure some people will disagree with. I believe we need to reduce usable FX reserves by about $1 trillion. My logic here is simple and straight forward. China will not exhaust every last dollar of reserves to defend the RMB, but will preemptively release the RMB giving them a cushion the continue facilitating international trade. I would peg that cushion at around $1 trillion, but that is really only a guesstimate of the point where they would release the RMB if forced. If we take all this into account, that leave China with about $2-2.4 trillion in FX reserves. The IMF actually pegs the amount of reserves China needs at a significantly higher $2.6 trillion. That means at current rates of USD depletion from the reserves, China has 10-12 months of RMB defense left before it floats if we use my $1 trillion baseline. However, if we use the IMF $2.6 trillion baseline, China only has about 3-4 months left if draining $200b a month to defend the RMB before it would need to float. As a final note to this, numerous measures of market belief indicate the market is betting on more devaluation despite official China protestations that the RMB is stable and appropriately valued. No one believes what Beijing is selling. The shaking of the world could very plausibly come much sooner than anyone expects.

3.Is it possible that I am wrong about the strength of the Chinese economy? Yes, absolutely it is possible, but I don’t think that is the most likely scenario. I have gotten some questions like this and without revisiting the discussions about why I don’t believe Chinese GDP data, let me explain my philosophical approach to studying the Chinese economy. First, I try to find consistency across data points. This doesn’t mean the data is uniform or reconciles perfectly, but that I see data moving in a similar direction. 7% GDP growth is inconsistent with flat or falling corporate profits and output. Flat or falling output is consistent with flat or falling corporate profits. Second, I try to focus on what is the most likely explanation. As an example, if we look across a range of goods and services comprising nearly 70% of Chinese GDP we see output is flat or falling. Believing that the Chinese economy is still rapidly growing based upon what we know already about nearly 70% of the economy would require taking large leaps of faith. For instance, that the remaining 30% of the economy is growing extremely rapidly. If we take a simple scenario where two-thirds of the economy isn’t growing and one-third of the economy is growing, to achieve a 7% total growth rate would require the sector that is growing to grow at 21%. While it is technically possible it is less likely and furthermore, this would violate our first idea of looking for data consistency in a bimodal distribution. There are numerous similar examples. While it is possible, it is definitely not the most probable explanation. I honestly fail to understand how anyone can believe that current GDP is the most probable outcome given all data issues. Again, it is possible, but far from the most probable.

4.One of the unexplored problems surrounding the Chinese slowdown is the relative lack of fiscal stimulus to play a meaningful role. Even leaving aside any discussion of credit and borrowing, though local governments being bailed out is never a good sign, it is unlikely that attempting to stimulate the economy on the fiscal side would have even a minimal impact. Stimulus capacity is exhausted in China. Corporately, firms are over leveraged with massive surplus capacity. Governments are also over leveraged with rapidly falling revenues and burdened with white elephant projects from the 2009 stimulus led building and credit orgy. The government would be better advised to simply drop money from helicopters than try and kick start the world’s second largest economy by pushing on string. Think of China as being near the zero bound of fiscal policy.

5.While there is much more scope for monetary policy intervention, China and the PBOC appear to be doing their best to destroy any appearance of competence by policy makers. First, China needs significantly lower interest rates. Producer price deflation which is in its fourth year is nearly 6% causing real interest rates for even the best firms to be north of 10%. Second, due to PBOC dollar selling, RMB is being sucked out of the economy quite rapidly. This implies increasing liquidity in a variety of ways is of the utmost importance. So far, the PBOC does not appear to be reinjecting RMB liquidity back into the economy. There have been small policy measures like reverse repo or other lending facilities, but these are both short term and not nearly large enough to make up the difference being drained from the system. What makes the problem with monetary policy so unnecessary is that China is inflicting this strait jacket on itself, spending about $200b a month on a policy even it knows will have to change sooner rather than later. By pegging the RMB it has to keep interest rates artificially high and spend dollars to buy RMB reducing liquidity. China is choking its own economy to peg the RMB to the $. There is only one scenario under which this policy makes real sense. If Beijing believes that (dirty) floating the RMB and releasing capital controls would prompt a flood of capital out of the country that would drain liquidity from the financial system prompting a banking crisis, this policy makes some sense. It definitely doesn’t solve the problem and only delays the day of reckoning, but that is undoubtedly a worse outcome and may help explain the current policy. Given the slight tightening in capital outflows we have seen, this would seem to make some sense. In other words, while China may be causing itself some pain by keeping interest rates high and tightening liquidity in a weak and slowing economy, the other obvious option might, as the hypothesized Beijing trade off goes, precipitate a currency and banking crisis. Beijing is choosing the lesser of two evils though this isn’t all that comforting for the rest of us.

6.Watch the opening. Now that the parade is over and with a few days off, don’t be surprised if the markets are under real pressure.

7.ICBC and BOC are the canaries in the coal mine. It’s coming.

8.Fact of the day: China has seen more PE fund liquidiations 2015 YTD than all of 2009.

9.Update: PBOC released FX decline for August today where they report a $94 billion decline to $3.56 trillion. Given that Barclays Research had estimated a range of$86-122and Deutsche Bank had estimated a post August 11 decline between$98-145billion, the $94 billion is right in line if a little on the low side. The decline is a little less then anticipated and while this is positive, I would be careful against rejoicing. All indications remain that capital outflows continue to accelerate, the offshore rate is diverging from the onshore rate by almost 1.5%, and the PBOC continues to intervene enormously to prevent further devaluation. I doubt the market will see this as stabilization. I would expect intervention to maintain similar levels in September.